Here's Why Linewell Software (SHSE:603636) Can Manage Its Debt Responsibly

Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. Importantly, Linewell Software Co., Ltd. (SHSE:603636) does carry debt. But is this debt a concern to shareholders?

When Is Debt Dangerous?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we examine debt levels, we first consider both cash and debt levels, together.

Check out our latest analysis for Linewell Software

What Is Linewell Software's Net Debt?

The image below, which you can click on for greater detail, shows that at September 2023 Linewell Software had debt of CN¥1.40b, up from CN¥626.5m in one year. However, it does have CN¥332.6m in cash offsetting this, leading to net debt of about CN¥1.07b.

A Look At Linewell Software's Liabilities

Zooming in on the latest balance sheet data, we can see that Linewell Software had liabilities of CN¥2.89b due within 12 months and liabilities of CN¥159.8m due beyond that. On the other hand, it had cash of CN¥332.6m and CN¥2.43b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥292.5m.

Since publicly traded Linewell Software shares are worth a total of CN¥6.98b, it seems unlikely that this level of liabilities would be a major threat. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time.

In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Strangely Linewell Software has a sky high EBITDA ratio of 6.3, implying high debt, but a strong interest coverage of 1k. So either it has access to very cheap long term debt or that interest expense is going to grow! It is well worth noting that Linewell Software's EBIT shot up like bamboo after rain, gaining 66% in the last twelve months. That'll make it easier to manage its debt. When analysing debt levels, the balance sheet is the obvious place to start. But it is Linewell Software's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last three years, Linewell Software burned a lot of cash. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Our View

We weren't impressed with Linewell Software's net debt to EBITDA, and its conversion of EBIT to free cash flow made us cautious. But like a ballerina ending on a perfect pirouette, it has not trouble covering its interest expense with its EBIT. Considering this range of data points, we think Linewell Software is in a good position to manage its debt levels. But a word of caution: we think debt levels are high enough to justify ongoing monitoring. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. For example Linewell Software has 4 warning signs (and 2 which shouldn't be ignored) we think you should know about.

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.